Monday, August 20, 2007

Yes, it's back with a vengeance. From every corner of the kingdom (see here and here), analysts are screaming "Bailout!" in response to the Fed's reduction in its discount rate and change in policy stance.

But is it? The premise of the criticism is that the Fed has rescued Wall Street and well-heeled investors in the recent past (the 1998 LCTM debacle, the tech bubble), thereby encouraging even more reckless behavior, such as that associated with the subprime mess.

Excuse me, but this doesn't make sense. LCTM did go bust, many persons lost fortunes speculating on Russian debt, and the Nasdaq is at half the level it reached in its 2000 peak. And cutting rates now won't do much to reduce the losses in bonds backed by junk mortgages. So it's not a question of rescuing investors, but of making sure that speculative excesses don't spill over to the economy. I don't blame the Fed for doing what it's doing (albeit in a rather clumsy way).

The hissy fit over alleged bailouts is unhelpful, as it distracts from asking the truly important questions:

1) Why have there been so many speculative excesses in such a short period of time?2) Should central banks actively try to nip bubbles in the bud? 3) Do hedge funds and other highly-levered investment vehicles need to be regulated more strictly as potential sources of financial destabilization?